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Got multiple locations? Expect auditors to keep a close eye on inventory

Do you remember the high-profile fraud that happened at drugstore chain Phar-Mor in the 1990s? Executives manipulated the company’s financial statements to hide approximately $500 million in losses.

A key ploy that perpetrators used in the Phar-Mor case was to overstate inventory balances at individual stores. Management became adept at hiding the scam from their financial statement auditors by shifting inventory from location to location and overstating unit prices. Dishonest managers also stocked the shelves at locations they knew their auditors would visit, leaving shelves barren at unaudited locations.

CPAs have learned a lot about fraud since the 1990s, and they’ve beefed up their inventory auditing procedures to prevent similar shenanigans. Here are some of the techniques that auditors use today to evaluate inventory as part of a multilocation audit.

1. Reviewing the inventory manual

Before venturing into the field to view inventory in person, your auditors will request a copy of the company’s inventory manual. This helps them understand the policies and procedures you use to manage inventory. Throughout the audit, auditors will compare the company’s inventory records against the manual for discrepancies and exceptions.

2. Conducting in-depth analytical procedures at each location

In order to safeguard against bloated inventory balances, your auditors will review the company’s accounting records. This helps them understand the process to allocate and assign inventory units and costs to individual locations. It includes verifying that the balances and associated value conform to U.S. Generally Accepted Accounting Principles (GAAP).

3. Counting inventory

Depending on the size of your company’s inventory, the auditor may conduct independent inventory counts or observe physical inventory counts that are conducted in-house or by third parties. As part of the inventory observation process, your auditor team may randomly select a sample of items and verify that those items are included in the inventory count. Alternatively, the auditor may select an item that appears in the inventory count and then attempt to locate that item in the company’s stores. At the conclusion of the physical count, the auditor may also perform statistical sampling to test the accuracy of the physical inventory count.

4. Analyzing general ledger entries

The perpetrators of the Phar-Mor fraud periodically made fictitious journal entries to the general ledger to allocate losses to the individual stores. So, auditors have learned to pay close attention to large or suspicious journal entries that reallocate losses or manipulate inventory balances. If anomalies are detected in general ledger transactions, your auditor will ask for documentation and detailed explanations from management regarding the purpose of the entry.

A custom approach

Inventory manipulations have played a key role in countless frauds. So, auditors have learned to pay close attention to the inventory account. The scope and depth of inventory auditing procedures depend on a number of factors, including the number of locations you operate. Contact us for more information about what to expect as auditors review your inventory balances in the coming audit season.